Europe has been a seller's market for some years now, and this is reflected in real estate purchase agreements, say a number of leading law firms contacted by PropertyEU for our first-ever ranking of top legal advisers on major cap deals.
There are plenty of wise sayings about the art of winning a negotiation. But no matter how accomplished the lawyer might be for a buyer, the strength of the underlying property market is perhaps the greater deciding factor.
For some years now, Europe has been a seller’s market. Sure enough, certain seller-friendly contractual terms have become increasingly frequent in purchase agreements. As Volker Zerr, a partner in CMS Germany says: ‘High and rising prices always point to a sellers’ market, and our detailed analysis of purchase agreements underlines how sellers are translating their strong negotiating positions into contractual advantage.’
CMS undertakes an annual study examining the frequency of clauses across the transactions it has acted on. The latest CMS Real Estate Deal Point Study was published in October. It is a 40-page study covering more than 1,300 transactions in 14 countries that CMS was involved in during the years 2010 to 2017.
It is very apparent from reading the report that sellers have indeed enjoyed the upper hand. It seems they have felt empowered because of continuing high demand stemming from a lack of alternative investment options, low interest rates and a positive economic environment as well as limited supply.
These factors seem to mean that hungry bidders lining up for precious assets for sale have a weaker negotiating position and will therefore tend to comply with a seller’s terms or else potentially miss out on the deal.
Maximum liability clauses
For almost all of the clauses it examined, CMS found that those ostensibly friendly to the seller have increased in use sometimes to reach record levels (see box). For example, it found that in 66% of the 1,300-plus agreements it examined, those in 2017 contained a maximum liability clause. This does what it sounds like it does - restricts the amount a seller can be liable to the buyer for should the buyer have a grievance. Such a grievance might occur due to a defect with an asset or title it has acquired. CMS says 66% is the highest figure the firm has recorded in the seven-year period in question and is double the frequency it recorded for 2010.
To limit a seller’s liability in the first place is obviously an advantageous thing for a seller. It is now common practice to write individual liability provisions into agreements rather than to abide by statutory warranties, which can be more generous to the buyer. The proportion of agreements in which the statutory warranty provisions were not excluded (insofar as they exist in a particular country) was less than 10% in the period covered by the study, with the average being 6%. More to the point, the lowest level in the survey period was reached in 2017, at just 4%. Deals with individually-drafted liability provisions have thus become established as the absolute market standard in the past three years.
Exclusion of liability
One of the most fascinating aspects of seller-friendly terms is to what extent a seller can restrict liability or warranties if the buyer had ‘knowledge’ of the issue it is complaining about. ‘Knowledge’ is a debatable thing and is therefore spelt out in agreements. Exclusion of liability if the buyer had knowledge of the issue or was negligent in not knowing is very common. For example, in 67% of contracts, a buyer agreed the seller would not be liable if the disclosure was made in the data room compared to 35% in 2013.
Terms are also more favourable to the seller when they address how long a buyer might have to make a claim. What the market now sees is the preponderance of short, seller-friendly warranty limitation periods of 6 to 18 months. Seller-friendly ‘de minimis’ and ‘basket clauses’ are also seller-friendly provisions that were agreed in more than half of all transactions in 2017. Furthermore, providing for a maximum contractual liability (a cap) was agreed in two-thirds of the evaluated agreements, the highest figure ever since 2010.
But apart from demonstrating how sellers have been able to insist on terms to protect themselves, CMS’ study also shows how some terms have become more common because of a sense of confidence in the real estate market.
A good example is the rise in provisions for purchase price adjustments. Purchase prices may not always be set in stone between the parties, particularly for forward purchase development agreements for which rental income might be an unknown quantity at the time a purchase contract is agreed. In the real world, the value of an investment would depend on what is achieved in terms of gaining a permit, the exact sq ft measurement, and the detail of rental agreements. Not only has there been an uptick in terms allowing for the future adjustment of the price but also in earn-out clauses. This is no doubt because sellers have been feeling bullish about their development – enough to gamble on earning a higher price if certain objectives are met than accept a lower price upon signing. CMS says last year saw the highest figure so far in the period under review for purchase price provisions. The key factor in this respect is the high proportion of forward deals (development project transactions) over the past two years.
A second example of confidence among sellers is to do with the financial strength of a potential buyer. If sellers are concerned about a potential buyer’s capacity to come through with the money they can insist on a mechanism. This can mean insisting on payment into an escrow account. But sellers do not seem overly bothered with this. CMS found the level has remained consistently at only around 50% in the last three years. ‘One of the factors here is probably the high proportion of financially strong institutional investors on the buyer side,’ the law firm says. It also reports a notary’s escrow was used in 27% of sales in 2012 but that figure has fallen in the last two years. It has been more popular to seek advance payment on the purchase price, or a guarantee provided by a third party or an escrow operated by a law firm or bank. Such methods are found in 25% of deals.
The other fascinating aspect of the study is how the use of clauses vary from country to country or at least European region. For example, though it is common for sellers to exclude liability for something the buyer ‘knew’, some countries seem to say this more than others. For example, in Germany and Austria, 83% of contracts have this clause but in Western Europe it occurs in 69% of deals and in other regions it drops to 50%. Again, in Germany and Austria, 58% of contracts exclude liability due to grossly negligent ignorance of facts on the buyer’s part, but that kind of exclusion is only found in 11% of transactions in Western Europe.
Other regional differences pop up everywhere. For example, provisions for purchase price adjustment were agreed in an average of only 15% of the transactions analysed in the German-speaking countries. This figure is markedly lower than in Western and Eastern Europe (Western European countries: 33%; Eastern European countries: 49%).
Limits on liability such as de minimis clauses (28%), basket clauses (23%) and liability caps (36%) were agreed less often in the Western European countries than in transactions conducted in the German-speaking and Eastern European countries. Compared with other countries, limits on liability such as de minimis clauses (68%), basket clauses (53%) and caps (87%) were agreed with much greater frequency in the Eastern European countries.
It is not just CMS that is aware of the trends highlighted above. Other legal advisers contacted by PropertyEU concur the market has given rise to more seller-friendly terms.
Evan Lazar, co-chairman of the Global Real Estate Group at Dentons who looks after a team of 300 lawyers across Europe, says his firm has seen this in the case of clauses relating to warranty and indemnity insurance that offer protection in the case of a breach of a warranty by the seller.
Lazar says that two or three years ago, buyers would ask sellers for various warranties and indemnities when they were perhaps concerned about the seller’s financial standing or warranties. They might also be concerned about a seller’s attempt to put a cap on liability.
‘What we are seeing in 2018 where there are more buyers than sellers is that sellers are saying to buyers either that they accept the minimal warranties or pay the costs of warranty insurance,’ says Lazar. ‘We do not see that everywhere on every deal, but it is a trend and we have seen it on many.’
Ciaran Carvalho, co-chair of CMS Global Real Estate Group, agrees. ‘On sales and purchases of corporate vehicles, warranty and indemnity insurance is increasingly the norm. That means transactions can take a week or two longer, but it helps those sellers who want a cap on liabilities.’
Edited excerpts from CMS’s Real Estate Deal Point Study 2018
Limits on liability
When a buyer enters into a contract to acquire an asset, it wants the right to be able to claim against the seller perhaps if it turns out there is a defect in the property or title. But there are a few mechanisms in real estate contracts to minimise liability for the seller, and such clauses have been tipped in their favour in the past year. Here the some of the most common of them.
- A liability cap
The seller stipulates that it cannot be liable for a figure above a stated amount. *Finding: CMS found that the year with the highest proportion of agreements with a contractually-agreed maximum liability clauses was 2017. It reached 66% in 2017, the highest-ever level in the period covered by the survey. The percentage has more than doubled since 2010. This clearly indicates a seller friendly trend. Looking only at transactions worth more than €100 mln, the proportion of agreements with a cap was even higher, standing at 82% in 2017.
- A de minimus clause
In an opposite tactic to the liability cap, sellers can insist not to be bothered with trivial claims from buyers by stipulating a claim will only be considered if it exceeds a certain amount. *Finding: The highest figure in the period under review was reached in 2017 (50%) having already risen to 45% in 2016. This further increase reflects the strong bargaining position enjoyed by sellers.
- A basket clause
These are closely connected with de minimus clauses and stipulate that the buyer can only assert a warranty claim if the aggregate of individual claims that exceed the de minimis threshold exceeds the basket threshold. A basket clause is consequently a seller-friendly provision. Just as with de minimum clauses, the percentage has risen from 45% of contracts in 2016 to the highest figure in the period under review - 50%.
- Limitation period
It is in the interests of the seller to get the buyer to agree a maximum time limit after which a claim cannot be lodged against it. Limitation periods in real estate contracts are usually shorter than the statutory maximum allowed under a country’s own law. Finding* There has also been a clear rise in the number of contracts that provide a limitation clause. CMS expresses this by saying the number of contracts without a limitation period (and thus leaving it to a nation’s statutory limit which tend to be more generous to buyers) fell to just 18% of case in 2017 from 56% in 2016. Furthermore, there has been a trend towards shorter limitation periods of 6 - 18 months in real estate contracts.
Things can go wrong in a real estate transaction that can upset a buyer. But the situations in which a buyer can claim against the seller for breach of warranty can, and frequently are, limited. One method is by excluding liability on the part of the seller if the buyer had knowledge of the relevant circumstance when the agreement was signed.
Finding* The chart here shows there was no provision for excluding liability when a buyer had knowledge of an issue in only 21% of cases. Clauses that restrict liability for information provided in the data room are now very common. They occur in 67% of contracts.
Furthermore, contracts can contain ‘objective’ and ‘subjective’ clauses. An objective guarantee is buyer-friendly because it means the seller can be liable even if the seller was unaware of a problem. In 2015, the percentage of agreements that only included buyer-friendly ‘objective’ guarantees was 25% but fell in 2016 (15%) before plummeting to 5% in 2017. In contrast, the proportion of agreements in 2017 that only included subjective guarantees was significantly above the level of the previous years. A subjective guarantee will help the buyer only when the buyer can prove the seller was aware of the issue.
Notwithstanding the above, there is evidence of some evenness overall. The proportion of transactions including both objective and subjective guarantees has risen over the last three years from 63% in 2015 and 71% in 2016 to 75% in 2017.
Provisions for adjusting the price
The contracting parties may agree either a fixed price or a variable price. *Finding: Last year saw the highest figure so far in the period under review. The key factor in this respect is the high proportion of forward deals (development project transactions) over the past two years, in which sellers benefited from positive market trends through purchase price adjustments and earn-out clauses. It should be noted, however, that purchase price adjustment clauses are still not the norm across real estate deals as they exist in about 28% of cases.
This is yet another mechanism designed to safeguard a seller. The seller wants to be confident a potential buyer is good for the money. One option is to insist on the buyer paying funds into an escrow account. Finding*: It is actually quite common for there to be no such protection for the seller, so this is one area where it cannot be said terms have reflected the seller’s market. Overall, CMS says the percentage of contracts where there was no safeguarding mechanism in fact rose to 53% in 2017 from 52% in 2016. One of the factors in this rise is probably the high proportion of financially strong institutional investors, such as pension funds and insurance companies, the law firm says.